Not the right time for arbitrage funds

Between March 2012 and January 2013, the National Stock Exchange (NSE)’s volatility index, or India VIX, fell from 28.92 to 13.71. When volatility goes down in the equity market, the arbitrage opportunity for investors and traders also falls.

Arbitrage opportunity arises when there is a difference in prices of an asset between two or more markets. For example, there could be a difference between a stock’s price on BSE versus NSE, or a difference in prices of an asset in the spot (cash) market and the futures (derivatives) market, or a difference between this month’s future contract and the next month’s future contract.

According to mutual fund rating agency Value Research, arbitrage funds from mutual fund houses have given nine per cent returns against the Sensex’s 24.5 per cent and Nifty’s 27 per cent over the past year.

But these funds have lost their sheen and the assets under management (AUM) have fallen in 2012. Earlier this month, Goldman Sachs Asset Management decided to close down two of its arbitrage schemes— Goldman Sachs Derivatives Fund and Goldman Sachs Equity and Derivatives Opportunities—which had assets of less than Rs 10 crore between the two of them.

Value Research data also shows the AUMs of arbitrage schemes across fund houses, except IDFC MF and Reliance MF, have fallen in the past year. As on December 2012, the assets of HDFC Arbitrage Retail fell to Rs 28.08 crore from Rs 51.76 crore a year earlier, while assets of ICICI Prudential Equity Arbitrage fell to Rs 32.14 crore vs Rs 47.01 crore. In the same period, IDFC Arbitrage Fund saw its AUM increase to Rs 83.65 crore (from Rs 57.61 crore in December 2011).

There are good reasons why arbitrage funds lost assets in 2012. Hemant Rustagi of Wiseinvest Advisors says: “With interest rates likely to head down, investors can consider dynamic bond funds or long-term debt funds. These can give double digit returns, which arbitrage funds may not be able to. Only when stock markets fluctuate will you get room for arbitrage. As equity markets stabilise, there may not be as many opportunities for arbitrage. Now, equity markets look stable and the bias is upwards.”

In such an environment, the returns from arbitrage and liquid funds become comparable. In the past year, liquid debt funds have also earned nearly nine per cent.

Going forward, arbitrage funds could provide some short-term investment opportunities. Says Feroze Azeez, director and head - investment products, Anand Rathi Pvt Wealth Management: “If the short-term interest rates come down, arbitrage funds will become lucrative short-term investments. Last year, arbitrage funds were not a recommended option as conventional debt funds were yielding higher returns. But with rates expected to fall, returns from liquid funds will also fall.” He adds arbitrage funds may also be able to find better opportunities as the fund size reduces.

The good part about arbitrage funds is that they cut the risk of equity, but get tax treatment like equity funds. Reason: These funds buy in cash and sell in futures, and avoid taking directional bets on equities. Hence, are less risky. But since these funds invest in the equity market, the tax treatment is similar to equity funds, which means there is no capital gains tax if you hold them for over a year.